Fiscal policy

Economics · Government and the macroeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

The government budget is its plan for revenue (mostly from taxes) and spending for the year ahead. If spending is more than revenue there is a budget deficit. If revenue is more than spending there is a budget surplus.

Fiscal policy means changes in taxes and government spending made to influence total demand. Expansionary fiscal policy (lower taxes, higher spending) raises total demand, so output and jobs rise, but inflation and imports may rise too. Contractionary fiscal policy (higher taxes, lower spending) does the opposite and is used against inflation.

Taxes are direct (on income and wealth) or indirect (on spending). A progressive tax takes a larger percentage of income as income rises.

Rules to remember

Budget balance = government revenue − government spending. Positive: surplus. Negative: deficit
Direct taxes: income tax, corporation tax. Indirect taxes: sales tax (GST or VAT), excise duty, tariffs
Progressive: the percentage of income paid in tax rises as income rises. Proportional: it stays the same. Regressive: it falls as income rises
Reasons to tax: raise revenue, discourage demerit goods, reduce imports, redistribute income, influence total demand, protect the environment
Expansionary fiscal policy: cut taxes or raise government spending, so total demand rises
Contractionary fiscal policy: raise taxes or cut government spending, so total demand falls
Main spending areas: education, healthcare, defence, infrastructure, welfare benefits, interest on government debt

Common mistake

Judging a tax by the amount paid instead of the percentage. With a regressive tax a rich person may still pay more rupees; it is the percentage of income paid that falls.

Worked example

In a country the first Rs 50,000 of monthly income is tax free and the rest is taxed at 20%. Asad earns Rs 100,000 a month and Bina earns Rs 250,000 a month. Is this tax progressive, proportional or regressive?

Asad: tax = 20% of (100,000 − 50,000) = Rs 10,000, which is 10,000 ÷ 100,000 × 100 = 10% of his income.
Bina: tax = 20% of (250,000 − 50,000) = Rs 40,000, which is 40,000 ÷ 250,000 × 100 = 16% of her income.
The percentage of income paid rises from 10% to 16% as income rises.

Answer: The tax is progressive, because the higher earner pays a larger percentage of income in tax.

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